The issuance, offer and initial sale of municipal bonds are regulated by federal securities law. The laws require bond issuers to provide these disclosures at the time the bonds are issued. Certain aspects of subsequent sales of issued securities are governed by the Securities and Exchange Commission (“SEC”) Rule 15 c2-12 (“Rule 15 c2-12”). Rule 15 c2-12, in part, mandates that brokers and dealers transacting in municipal bonds have reliable access to material information concerning the bond issuer's financial condition. This necessitates that bond issuers (or their agents) make certain disclosures over the lifetime of the bond. For example, the issuer must make certain periodic filings and must disclose certain material events as they occur.
Traditionally, disclosing this information in a satisfactory and coherent manner was difficult. As a result, brokers and dealers had difficulty accessing information regarding a municipal bond prior to recommending it to a customer. This created certain problems for broker/dealers when trying to comply with Rule 15 c2-12.
For some time, the SEC has required bond issuers to disclose the above-mentioned information to Nationally Recognized Municipal Securities Information Repositories (NRMSIRs), State Information Depositories (“SIDs”), and disclosure information systems established and operated by the Municipal Securities Rulemaking Board (“MSRB Systems,” and, together with NRMSIRs and SIDs “Municipal Disclosure Repositories,” referred to herein as MDRs).
MDRs serve as points where information could be deposited by issuers and retrieved by interested parties. As a means of preventing fraud in the municipal market, Brokers and Dealers (as those terms are legally defined by the SEC) in municipal securities are required to have access to systems, (including, for example, Municipal Disclosure Repositories) that provide reliable information about municipal issuers and their bonds.
Issuers, however, have had difficulty in fully utilizing NRMSIRs, SIDs and MSRB Systems. Some issuers have contended that NRMSIRs are not “user friendly,” and that there is little feedback when incomplete information is accidentally submitted. Further, NRMSIRs do not affirmatively remind issuers when information is due to be submitted. Brokers and Dealers transacting in municipal bonds have had some difficulty in meeting regulatory requirements because of uncertainty over the reliability of information available through NRMSIRs. Specifically, whether information required to be filed was, in fact, filed and, if filed, whether the information was actually received has been difficult to determine. Brokers and Dealers have complained that the information on file at the NRMSIRs is inconsistent and the SEC staff has noted inconsistent filings among NRMSIRs in sample studies. Also, Issuers traditionally could not easily verify that their disclosure filings have been received and accurately filed with NRMSIRs, SIDs and MSRB Systems. As a result, Brokers and Dealers transacting in municipal bonds sometimes could not, with certainty, comply with current regulatory mandates such as the Rule 15 c2-12.
In order to address these and other issues related to the distribution and dissemination of information related to Issuers and the securities they issue (e.g., related to material events, etc.), Digital Assurance Certification LLC (“DAC”) developed a system for gathering information from Issuers of municipal securities and distributing information evenly to municipal disclosure repositories, regulatory bodies and the public. One aspect of the DAC system is a computer application, which can be implemented on a computer system that is attached to a network of computers and other communication devices, such as the Internet, and that enables Issuers to securely enter ongoing information (e.g. periodic filings and material event notes) about one or more bond issues. This information may include annual audits of the issuer, certain operating data, and any event notices deemed material by the issuer. Such information is provided to comply with the contractual obligations of the issuer to the bond holders and to provide Brokers and Dealers with a procedure for meeting regulatory requirements that provide prompt notice of events relating to bonds they recommend to customers. For information that is required to be submitted on a periodic basis, the system determines when the information is due to be submitted, and prompts the issuer to file such information with the system. This information is then published to the public, and, simultaneously, transmitted to the municipal disclosure repositories and/or regulatory bodies via a one-click dissemination system.
In the DAC system, if the issuer does not submit the required information by the due date, the system generates a notice that the required information was not submitted by the issuer. Additionally, the system establishes an audit trail for gathering and distributing information. Another important aspect of the audit includes receiving and archiving a receipt that information was transmitted to the MDRs and/or one or more regulatory body. Additionally, the system provides a secure platform for communication among issuers and their investors via electronic mail and teleconferencing. Additional information regarding the DAC system may be found, for example, in U.S. Pat. No. 7,155,408, entitled “Method and Apparatus for Managing Information and Communications Related to Municipal Bonds and Other Securities”, which is incorporated herein by reference in its entirety.
The SEC also regulates some of the institutional purchasers of debt instruments, like bonds and/or other long-term financial instruments. For example, money market funds typically invest in corporate debt, government treasury debt, government agency debt, and/or other debt. With the return on these (and other) investments, a money market fund may provide a return to its account holders (as well as profit for itself). Money market funds tend to invest in short-rated debt. This typically includes instruments that may not be regulated by the SEC in the same fashion as traditional long-term bond issues. As a result, the SEC may enforce rules on the money market funds that require the funds to self-regulate with respect to the types of instruments that they purchase. For example, SEC Rule 2a-7, 17 C.F.R. §270.2a-7, (“Rule 2a-7”) regulates money market funds and specifies the characteristics of investments to be purchased and held by money market funds. Regulating funds that may invest in issues that are unregulated has the effect of indirectly regulating the issues, as an issue may not be able to attract investors unless it enables potential investors to comply with the relevant regulations (e.g., Rule 2a-7)
The general requirements of the Rule 2a-7 include that a money market fund must (a) maintain a portfolio maturity appropriate to its objective of maintaining a stable net asset value or price per share, (b) limit its portfolio investments to those securities that the fund's board of directors determines (i) present minimal credit risks and (ii) are at the time of acquisition “eligible securities,” and (c) maintain a diversified portfolio. Furthermore, money market funds are required by the Rule 2a-7 to evaluate securities in their portfolios at the time of acquisition and periodically thereafter for compliance with these provisions of the Rule.
As has been mentioned above, three of the basic requirements of Rule 2a-7 may include (1) portfolio maturity, (2) portfolio quality, and (3) portfolio diversification. With respect to portfolio maturity, Rule 2a-7 generally prohibits a fund from acquiring any instrument with a remaining maturity from trade date of greater than 397 calendar days. Additionally, Rule 2a-7 may require the fund to maintain a dollar-weighted average portfolio maturity of 90 days or less. However, funds may rely on demand features, insurance, or other third party guarantees (such as the demand feature of a variable rate demand note) as a maturity-shortening device under Rule 2a-7. As will be discussed further below, a demand feature or other guarantee of a security such as a variable rate demand note may either be conditional or unconditional. A conditional guarantee may include a guarantee that is limited by certain conditions.
Reliance on a guarantee to meet Rule 2a-7's maturity restrictions with respect to a given security may essentially require one or both of (i) a credit risk determination by the purchaser/holder on the guarantor (e.g., the issuer of the guarantee), as well as the issuer of the primary security, and/or (ii) an assessment of any events that may lead to the termination of a conditional demand feature. This may be the case because the reliance on the guarantee provided by the guarantor may be roughly equivalent to the purchase of a put option on the primary security from the guarantor that enables the overall position to meet the maturity requirement of Rule 2a-7. In other words, the purchase of a security like a variable rate demand note may be viewed in some respects as a purchase of two separate securities, the note itself, which is the primary security, and the guarantee (or put option) that is provided, or issued, by the guarantor. Therefore, some analysis of the secondary security (e.g., the guarantee) included in a variable demand note (or similar instrument) may be necessary to meet the maturity restriction (and/or other restrictions) of Rule 2a-7.
In some instances, information related to the credit risk of the issuer of the guarantee and/or the conditions of the guarantee may be inconvenient for a purchaser/holder to obtain. This may be for a variety of reasons including, for example, that generally issuers of guarantees on instruments issued by municipalities refuse to make information regarding their credit-worthiness, the terms of their agreements with issuers, and/or other information related to their operations available to the general public. Further, there may be no secure, accessible mechanism for an issuer to provide this type of information to purchaser/holders.
With respect to the portfolio quality requirement of Rule 2a-7, Rule 2a-7 generally provides that a money market fund shall limit its portfolio investments to securities that the fund's board of directors determines present minimal credit risks and that are at the time of acquisition eligible securities. The fund board's determination must be based on factors pertaining to credit quality in addition to any rating assigned to such securities. Typically, money market funds may not be able to buy or hold a security unless it is rated in one of the two highest short-term rating categories by a requisite number of nationally recognized rating agencies or, if unrated, the security is determined to be of comparable quality to such rated securities. However, this may be a necessary, but not a sufficient condition, as rating agency ratings on a security are considered under Rule 2a-7 to be relevant to credit quality, but not overall eligibility under Rule 2a-7. Each security purchased by a money market fund must also satisfy an independent determination by the board (and/or an investment adviser that reports to the board) that it presents “minimal credit risk” to the fund. If a security no longer presents credit risk, or if the fund has insufficient information to maintain minimal credit risk determination, the fund must (under Rule 2a-7) dispose of it as soon as practicable.
As was mentioned above, some securities that include guarantees (e.g., including a demand feature), such as a variable rate demand note, actually may be analogous to two separate securities (the primary security and the underlying guarantee). Therefore, in order to purchase and/or hold a security that includes a guarantee, a purchaser/holder governed by Rule 2a-7 must be make a determination as to the credit quality of the guarantee. Typically a guarantee may include (1) a letter of credit, (2) a financial guaranty (e.g., bond) insurance, and/or (3) a demand feature.
A demand feature may include an unconditional demand feature or a conditional demand feature. In order for a guarantee with a conditional demand feature to be an eligible security under Rule 2a-7, a purchaser/holder must have access to information that enables it to determine that there is a minimal risk of the occurrence of circumstances which would result in the conditional demand feature not being exercisable. In addition to the determination of the likelihood of occurrence of the condition(s) limiting exercise, Rule 2a-7 may also require that either (1) the condition(s) limiting exercise be monitored readily, or (2) that the fund will receive notice of the occurrence of the condition and the opportunity to exercise the conditional demand feature. Even though the terms of these guarantees (including the circumstances which result in the conditional demand feature not being exercisable) are not generally open to the public, the system and method disclosed herein may provide a mechanism that enables a purchaser/holder to receive such information via disclosures that are subject to restricted access.
With respect to the portfolio diversification aspect of Rule 2a-7, Rule 2a-7 may impose specific percentage limits on a money market fund's exposure to the issuers (both primary issuers and secondary issuers such as guarantors or other guarantors) of securities held in the fund with the aim of avoiding excessively concentrated credit risk. In order to comply with Rule 2a-7, a fund may be required to know at substantially all times the correct obligors and guarantors (e.g., remarketing agents, insurers, etc.) on securities owned by the fund in order to avoid violating the diversification percentages dictated by Rule 2a-7.
The Rule 2a-7 imposes both substantive and procedural requirements on investment companies managing money market funds. Every security purchased by a money market fund must by an “eligible security” under the Rule, satisfying the Rule's requirements for credit quality, portfolio diversification, and effective maturity. Since the goal of a money market fund is that its shares be liquidatable at par, the Rule 2a-7 provides how the current price per share is calculated for purposes of distribution, redemption and repurchase of any money market fund share. In calculating the current share price, the Rule 2a-7's requirements must be met and the fund's board of directors must determine, in good faith, that it is in the best interests of the fund and its shareholders to maintain a stable net asset value or price per share, by virtue of the permitted methodology of price calculations, only so long as the board believes that the method fairly reflects the market-based net asset value per share. Thus, events in the life of a security after acquisition by a money fund are as important as any that occurred prior to acquisition.
In order to attract investment from entities such as money market funds, some issuers may issue short-rated, long-term instruments, such as variable rate demand notes or other variable or floating-rate securities. However, for a variety of reasons the structure of these types of instruments may not lend themselves to investment by an entity, such as a money market fund, that is regulated by the Rule 2a-7. For example, the provisions of Rule 2a-7 may not be reflected in many forms of standard documentation for short-term and variable and floating-rate municipal securities.
A variable rate demand note is an example of a security that is not regulated by the SEC, and may have the potential to provide a money market fund with an investment option. However, due to one or more structural flaws in a given variable rate demand note, a note may or may not enable an investing money market fund to meet the requirements of the Rule 2a-7. Variable rate demand notes are floating rate instruments with terms of as much as 40 years. They may pay interest monthly or quarterly based on a floating rate that is reset daily or weekly based on an index of short-term municipal rates. Variable rate demand notes are purchased at par. Liquidity is provided with a put feature, which allows the holder to put the security for par plus accrued interest on any interest rate reset date, usually with one or seven days notice. A guarantor such as a bank or other entity typically serves as a liquidity provider. If a variable demand rate note is put back, it is put back to the guarantor, rather than the issuer. The guarantor may try to resell the variable demand rate note or, failing that, may hold the note in its own inventory. A variable demand note may typically have a credit enhancement such as a letter of credit from a guarantor or bond insurance.
While the demand feature of a variable rate demand note (e.g., the ability of the purchaser to put the note at par) may provide a degree of liquidity that enables a money market fund to meet the requirements of the Rule 2a-7 (e.g., portfolio maturity, credit worthiness, diversification, etc.), this may not always be the case. For example, the demand feature may be conditional and may not provide the fund with the requisite liquidity. Further, various aspects of a variable rate demand note may not be regulated by the SEC, thus, obtaining information related to the note, its issuer, and/or or its guarantor may be inefficient, inconvenient, and/or unworkable for a financial institution forced to comply with the Rule 2a-7.
While the DAC system, as originally configured, enabled issuers to make filings of disclosures and material event notices that become publicly available, this information did not necessarily enable money market funds to obtain all of the information that they needed to comply with Rule 2a-7. Some of the information needed to comply with Rule 2a-7 is generally not publicly available and some of the interested parties want to minimize certain types of information that becomes public (e.g. terms of guarantees, etc). Thus, the original DAC system, which was designed primarily to comply with Rule 15 c2-12, did not provide all of the information needed for funds governed by Rule 2a-7 (e.g., information that could not and/or should not be disseminated generally to the public) related to specific issuers and/or securities. Accordingly, in its original configuration, the DAC system would, in some instances, notify funds regulated by Rule 2a-7 that an event of interest had occurred with respect to a security (e.g., the substitution of an insurer or guarantor, as is discussed below), but did not enable these funds to securely and conveniently access all of the information that would dictate whether the event of interest would necessitate a liquidation, and/or prevent the purchase, of the corresponding security.